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It is not often that concepts like factoring/assigning/taxation are relevant for investing. But sometimes, one is shocked at the extent of opacity in financial accounts. For some context, the Supreme Court recently held that Essar Oil was not eligible for a sales tax deferment scheme it had availed, and that it must repay the nearly $1.2bn at once. In response, the market capitalization of Essar OIl and Essar Energy Plc(its holding company) crashed by around 40%, and the 4.25% bonds(due 2016) of Essar Energy now command a yield of 27%. But surprisingly, none has pieced together this bits of the jigshaw puzzle yet.

Thanks to the UK Regulator FSA Plain English doctrine, despite disclosing very little information to Indian investors, Essar Energy Plc  made a much more legible description of the dispute in the $550MM issue size bond prospectus of their 4.25 per cent. Guaranteed Convertible Bonds due 2016.

On page 9 of the prospectus(read it here,they described their sales tax dispute. I reproduce below the salient features of the dispute.

1. Under the Gujarat State investment subsidy scheme titled "Capital Investment Incentive to Premier/Prestigious Unit Scheme, 1995-2000" , if  Essar's Vadinar refinery could commence commercial production by 15 August 2003, then it would be allowed to retain interest free the proceeds of the sales-tax collected during the exemption period ,on sales of refined petroleum products from the Vadinar refinery. 

2. The exemption limit's sunset clause is earlier of 13 years from fiscal 2008-09(viz till fiscal 2021-22),or till cumulative sales tax worth 91 billion (presently US$1.8 billion) was collected.  which the company had expected in 2013-14.

3. After the sunset clause was triggered, the tax collected was repayable in six equal annual instalments. Till Dec10, Essar had utilized Rs.42.60 billion (US$950.68 million) detailed below. The amount rose to Rs 63bn by Dec11($1.235bn), and Essar must have booked 80% of that cumulative figure as revenue going by previous years trend.

4. Since Essar could retain the revenue and repay it in interest free installments, it recognized nearly 80% of the tax collections as its revenues(viz total collections net of the NPV of tax dues). For example, the revenue recognition impact of that was as below(figures in Rs bn)

Fiscal(all figs Rs bn) Tax Collected   NPV of tax dues Net Revenue recognized
Mar08-Mar09 15.16 3.01 12.15
Mar09-Mar10 14.74 2.95 11.79
Mar10-Dec10 12.69 2.78 9.91

5. Essar did not commission the project on time, yet availed the exemption. Driven by opposition clamour, the Gujarat Government reluctantly demanded the tax from Essar, which appealed the matter at the State High Court, where it won in Apr08. The State appealed the matter in the Supreme Court, where it was listed for hearing in Jul11, and order passed in Jan-12, where Essar was held ineligible to claim the benefit.

6. Meanwhile, Essar Energy Plc(Essar Oil's holding company) had launched an IPO in the UK, in Mar-10. Perhaps to reassure investors of the tax liability, Essar Oil  decided to "assign" that liability to its group company Essar House Limited, under a "factoring agreement". It should be noted that under law, Essar Oil remained ultimately liable for the payment of the sales tax liability to the state of Gujarat in the event that Essar House defaulted. Later, another Essar company guaranteed Essar House's obligations under a tripartie agreement.

7. In essence therefore, investors should not have had to worry about those tax dues payable by Essar Oil, even if it lost the Supreme Court ruling. This is because TWO Essar group companies have guaranteed the payments. However, the guarantee is contractual not statutory, with the onus of immediate payments resting on Essar Oil. 

Perhaps, investors are discounting this(both stock price and bond price) as they fear the promoter entities would find a way to wriggle out of paying the entire amount. After all, the promoter entities would  be suckers to pay 100% for having purchased at 28%. I'm sure high priced lawyers are working overnight on the agreement trying to discover loopholes for the unlisted promoter companies to escape, maybe by invoking a force majure clause etc. And the investor apprehensions seem justified. Compare the contrasting description of the factoring arrangements

1. In May11 bond prospectus:- While, pursuant to a factoring arrangement, the Company has assigned its sales tax liability under the sales incentive scheme of Rs.42.60 billion (US$950.68 million) to Essar House Limited (“Essar House”), an Essar Affiliated Company, at the present value agreed pursuant to the factoring arrangement of Rs.11.83 billion (US$264.0  million) and paid Rs.11.26 billion (US$251.28 million) to Essar House as of 31 December 2010. A plain reading of this arrangement and the meaning of factoring would imply that Essar House took the present upfront, agreeing to pay the tax dues whenever they materialized. Also, it would seem that Rs 42.6bn was assigned. 

2.In Jan12 announcement(, they said that As per previous disclosure, the sales tax deferment liability has been assigned to a third party. As of  December 31 2011, the amount assigned is Rs1800 crore (US$353 million). This amount is repayable to Essar Oil to meet any payments of the deferred tax benefit in accordance with the terms of the agreement. This implies that (i)The assigned amount was only the present value and (ii)Essar House will only repay the present value and NOT the total gross liability. This goes against all legal conventions and meaning of factoring, and is also contrary to the risk factor in the prospectus, which stated explicitly that the gross value was assigned.

But for investors savvy with accounts/law/tax, this is an interesting stock and bond to analyze, and to practically use the concepts we learn in CA course.Of course, corporate governance questions etc are raised, but only expected in these cases!

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(Bharti Airtel)
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